ANALYSIS

Lending is necessary for GDP rebound

lending-is-necessary-for-gdp-rebound

Greek government officials have highlighted the importance of debt relief and international creditors have stressed the significance of structural reforms in enhancing economic growth, while fiscal policy remains a controversial point. Political uncertainty and capital controls have clouded the outlook and pundits expect the economy to fall back into recession this year; some even expect it to shrink in 2016. In this context, the sooner the banking sector assumes its role and provides credit to the economy, the better.

The European Commission has downgraded its economic forecast on the Greek economy, now expecting it to contract between 2 and 4 percent this year, from a sluggish upturn of 0.5 percent back in the spring. Continuing deflation points in the same direction, with average consumer prices dropping 2.2 percent year-on-year in July for the 29th consecutive month. In addition, some leading indicators, namely survey data, such as the Purchasing Managers Index, are disappointing, recording an unprecedented drop last month.

On the other hand, officials from the tourism industry sound more cautiously optimistic lately, arguing it is feasible that receipts will equal last year’s record high. This is despite a sharp fall in domestic tourists on the back of political uncertainty and capital controls. Assuming an agreement is struck between the government and the lenders, political stability returns, fiscal policy does not become overly restrictive, the banking sector is recapitalized fast and the external environment is supporting, the economy could dip 2 to 3 percent this year and record an anemic advance in 2016.

One of the big ifs in this optimistic scenario is the fast recapitalization of Greek banks and the return of credit growth at some point next year. We have always argued the local banks should be overcapitalized to become anchors of economic stability in a period of high political uncertainty and economic strain for which they bear small or no responsibility. It is known local banks will undergo Asset Quality Review (AQR) tests to be followed by stress tests in order to determine their capital needs: an important step in restoring savers and others’ confidence in their ability to play their intermediary role and finance an economic turnaround.

Even under normal circumstances, the short-term consequences of the AQR tests are that the banks will have to clean up their balance sheets, and this will have a negative consequence on credit growth. European Central Bank President Mario Draghi has admitted in the past the AQR tests may have a negative effect on the banks’ willingness to lend.

Of course, the current Greek case is extraordinary and goes beyond that. In general, credit growth tends to lag GDP growth in recoveries and many doubt whether the Greek economy will start recovering in 2016 even if the banks undergo the tests and are recapitalized in the next three to four months.

Sure, some pundits argue countries can grow without counting on credit growth. A report by Citigroup had argued in the past that European Union countries with large foreign direct investment (FDI) inflow,s such as Ireland or where the private sector has strong liquidity positions such as Germany, UK, Spain etc, seem to grow fine without credit growth. But this is not the case in other countries that don’t benefit from strong FDI inflows and strong liquidity positions. In the latter group of countries, where Greece finds itself, the ability to access credit matters a lot. In fact, economic growth has to be credit-financed to become solid and pick up steam.

It is true that credit growth is a function of both credit demand and credit supply. In the past in Greece credit demand from financially sound companies was a more binding constraint for credit growth than credit supply.

Following the imposition of capital controls in late June – but even before – credit availability has overtaken demand in importance. Therefore, the banks’ role in providing credit is paramount at a time when local companies have exhausted their own funds and cannot raise external equity or borrow from debt markets.

This cannot happen overnight. It requires a more stable economic and political environment and the fast recapitalization of Greek banks. This way capital controls can be safely relaxed and finally removed, some deposits will return and banks will be able to restructure their nonperforming loan (NPL) portfolios with greater ease. It is estimated deposit outflows have exceeded 40 billion euros in the last six months or so, bringing deposits to less than 120 billion, while NPLs have surpassed 40 percent of total loans to more than 100 billion.

Although the damage to the banking system is serious, it does not mean it cannot be repaired. However, it will take time. Assuming bankers are right, most withdrawals were precautionary rather than linked to depleting cash reserves of the banks’ clients. Moreover, about half or more of the withdrawals were in cash, while the rest were equally split between transfers to money market funds and transfers abroad. These characteristics suggest that it is possible a portion of these outflows may flock back to the system once stability returns. Still, the amount will likely be lower than would have been the case without the imposition of capital controls.

There is no doubt the Greek economy has to grow to service its debts. This requires structural reforms, debt relief and rational fiscal policies – definitely not higher taxes that discourage productivity and promote tax evasion masked under the term of income redistribution. It also requires strong banks to relax capital controls and pave the way for a return to positive credit growth rates at some point in 2016.